Monday, December 9, 2013

Reality Refutes Mises on Costs and Prices

In a passage that should simply provoke hilarity to any person knowledgeable about real world prices, Mises shows us how far his economic theory is from reality:

“Any price determined on a market is the necessary outgrowth of the interplay of the forces operating, that is, demand and supply. Whatever the market situation which generated this price may be, with regard to it the price is always adequate, genuine, and real. It cannot be higher if no bidder ready to offer a higher price turns up, and it cannot be lower if no seller ready to deliver at a lower price turns up. Only the appearance of such people ready to buy or to sell can alter prices.

Economics analyzes the market process which generates commodity prices, wage rates, and interest rates. It does not develop formulas which would enable anybody to compute a ‘correct’ price different from that established on the market by the interaction of buyers and sellers.

At the bottom of many efforts to determine nonmarket prices is the confused and contradictory notion of real costs. If costs were a real thing, i.e., a quantity independent of personal value judgments and objectively discernible and measurable, it would be possible for a disinterested arbiter to determine their height and thus the correct price. There is no need to dwell any longer on the absurdity of this idea. Costs are a phenomenon of valuation. Costs are the value attached to the most valuable want-satisfaction which remains unsatisfied because the means required for its satisfaction are employed for that want-satisfaction the cost of which we are dealing with. The attainment of an excess of the value of the product over the costs, a profit, is the goal of every production effort. Profit is the pay-off of successful action. It cannot be defined without reference to valuation. It is a phenomenon of valuation and has no direct relation to physical and other phenomena of the external world.

Economic analysis cannot help reducing all items of cost to value judgments. The socialists and interventionists call entrepreneurial profit, interest on capital, and rent of land ‘unearned’ because they consider that only the toil and trouble of the worker is real and worthy of being rewarded. However, reality does not reward toil and trouble. If toil and trouble is expended according to well-conceived plans, its outcome increases the means available for want-satisfaction. Whatever some people may consider as just and fair, the only relevant question is always the same. What alone matters is which system of social organization is better suited to attain those ends for which people are ready to expend toil and trouble. The question is: market economy, or socialism? There is no third solution. The notion of a market economy with nonmarket prices is absurd. The very idea of cost prices is unrealizable. Even if the cost price formula is applied only to entrepreneurial profits, it paralyzes the market. If commodities and services are to be sold below the price the market would have determined for them, supply always lags behind demand. Then the market can neither determine what should or should not be produced, nor to whom the commodities and services should go. Chaos results.” (Mises 2008: 393).

Let us look through the litany of errors in this passage:

(1) Mises says that:

“Any price determined on a market is the necessary outgrowth of the interplay of the forces operating, that is, demand and supply.”

The word “necessary” in this sentence should raise eyebrows. And what type of “market” is Mises speaking of?

Is Mises referring to (1) real world markets or (2) imaginary, hypothetical markets that exist only in his head and where his “necessary outgrowth of the interplay of the forces … [sc. of] demand and supply” hold true? If the latter, then his analysis is irrelevant to reality, since the real world obviously departs from Mises’s ideal.

If Mises refers to the real world, then he is straightforwardly wrong.

To see this, we need only review what Mises means by “the interplay of the forces … [sc. of] demand and supply.” This is quite clear from the rest of his writings, such as the following:

(1) “The characteristic feature of the market price is that it equalizes supply and demand. The size of the demand coincides with the size of supply not only in the imaginary construction of the evenly rotating economy. The notion of the plain state of rest as developed by the elementary theory of prices is a faithful description of what comes to pass in the market at every instant. Any deviation of a market price from the height at which supply and demand are equal is – in the unhampered market – self-liquidating.” (Mises 2008: 756–757).

(2) “It is ultimately always the subjective value judgments of individuals that determine the formation of prices …. . Market prices are entirely determined by the value judgments of men as they really act.

If one says that prices tend toward a point at which total demand is equal to total supply, one resorts to another mode of expressing the same concatenation of phenomena. Demand and supply are the outcome of the conduct of those buying and selling. If, other things being equal, supply increases, prices must drop. At the previous price all those ready to pay this price could buy the quantity they wanted to buy. If the supply increases, they must buy larger quantities or other people who did not buy before must become interested in buying. This can only be attained at a lower price.

It is possible to visualize this interaction by drawing two curves, the demand curve and the supply curve, whose intersection shows the price.” (Mises 2008: 329–330).

(3) “The market interaction brings about a price at which demand and supply tend to coincide. The number of potential buyers willing to pay the market price is large enough for the whole market supply to be sold. If government lowers the price below that which the unhampered market would set, the same quantity of goods faces a greater number of potential buyers who are willing to pay the lower official price. Supply and demand no longer coincide; demand exceeds supply, and the market mechanism, which tends to bring supply and demand together through changes in price, no longer functions.” (Mises 2011: 101).

(4)“Competitive prices are the outcome of a complete adjustment of the sellers to the demand of the consumers. Under the competitive price the whole supply available is sold, and the specific factors of production are employed to the extent permitted by the prices of the nonspecific complementary factors. No part of a supply available is permanently withheld from the market, and the marginal unit of specific factors of production employed does not yield any net proceed. The whole economic process is conducted for the benefit of the consumers.” (Mises 2008: 354).

So real world prices must be determined by the “interplay of the forces ... [sc. of] demand and supply” in this sense. (That is, Mises is not simply using “demand and supply” in a weak and trivial sense of saying that a good must be demanded and valued by a consumer as a precondition of him buying it and physically supplied for him to do so.)

But real world capitalist economies have many prices – and in many cases a majority of prices – that are set by price administration. Such “administered prices” (or mark-up prices, average-cost prices, full-cost prices, normal cost prices, or cost-plus prices) are set by businesses based on average costs of production per unit plus a profit mark-up. For the empirical evidence on this, see the links in Appendix 1 below.

Administered prices (or mark-up prices) are not set by the conventional forces of supply and demand. They are not even intended to be market-clearing prices. They remain relatively inflexible with respect to demand, especially downward. Often they will not be changed for up to a year. When costs do rise, they might change or they might not: even price rises need not necessarily happen if businesses feel their competitors will not raise prices.

Such mark-up prices can be found in both consumer goods markets and intermediate goods and wholesale markets (Parker, pp. 6–7).

In short, these are prices that do not confirm to Mises’s strident statement about how prices are determined. And the empirical evidence shows that they normally account for the majority of business prices in most first world nations.

(2) Mises states that

“At the bottom of many efforts to determine nonmarket prices is the confused and contradictory notion of real costs. If costs were a real thing, i.e., a quantity independent of personal value judgments and objectively discernible and measurable, it would be possible for a disinterested arbiter to determine their height and thus the correct price.”

According to Mises, the notion of “real costs” is “confused and contradictory.” But it seems that Mises is inventing a straw man.

Even though any given costs as measured in money prices might well be related in some sense to subjective personal value judgments, it is still the case that money prices are an objective phenomenon that are “discernible and measurable.” If two people see the price of a good displayed, they might well disagree profoundly about why or if they subjectively value it, but they cannot disagree about the stated money price, without one of them being wrong or both being wrong. The money price is an objective thing in this sense.

“Prices are always money prices, and costs cannot be taken into account in economic calculation if not expressed in terms of money.” (Mises 2008: 349).

But that requires that money prices have a type of objectivity.

(3) Finally, we get this gem:

“The question is: market economy, or socialism? There is no third solution. The notion of a market economy with nonmarket prices is absurd. The very idea of cost prices is unrealizable. Even if the cost price formula is applied only to entrepreneurial profits, it paralyzes the market. If commodities and services are to be sold below the price the market would have determined for them, supply always lags behind demand. Then the market can neither determine what should or should not be produced, nor to whom the commodities and services should go. Chaos results.”

The idea of “cost prices” is definitely not “unrealizable.”

Such “cost prices” – prices based on total average unit costs plus profit mark-up – have long existed throughout the capitalist world. The existence of widespread administered prices has been documented since the 1920s.

It follows from Mises’s analysis that all advanced capitalist economies from at least the 1920s onwards should be in a permanent state of “chaos”: for in most of them probably the majority of prices are relatively inflexible, not properly set by supply and demand, nor set to converge to market-clearing levels.

According to Mises, we should have “chaos” where “supply always lags behind demand” in these markets.

But we do not have chaos, nor do we see such chronic supply problems in capitalist nations.

Mises is contemptibly ignorant of real world capitalism: a world where most firms set their mark-up price based on average unit money costs of production, and then adjust production to match demand, while keeping inventories and significant unused capacity at factories and plants available to meet increases in demand. When demand falls, businesses fire workers and cut production.

“Mark-up Prices in Iceland,” November 25, 2013.
This cites a survey of 580 Icelandic firms and finds that mark-up pricing is the largest type of pricing at 45%. Evidence suggests that more mark-up prices are concealed in the other categories in the survey, so that real percentage is higher than this.

“Mark-up Pricing in Australia,” November 30, 2013.
This cites a survey of around 700 Australian firms that finds that mark-up prices account for at least 49% of firm prices. Once we add likely mark-up prices concealed in the other categories in the survey, the percentage possibly rises to 60%.

17 comments:

Any economy no matter how simple must have at least one price that is not based upon costs or there is no cost to base the rest if the prices on.

A simple model based on homogeneous labor alone could probably use labor-time as the basis for costs but even here a "price" would have to allocated to labor that was not based upon costs.

As soon as you introduce scare raw materials or non-homogeneous labor into the model then you need the prices of each of these things to be set not based upon cost. Further: you need the relative prices of these "originary factors" to be set appropriately or the economy will fail to allocate resources in a viable manner.

Look at the definition of "unrealizable": "unable to be realized, or made real or realistic; convert into actuality".

When Mises says "The very idea of cost prices is unrealizable", he is saying the very notion of a cost based price cannot be made real, not that "Any economy no matter how simple must have at least one price that is not based upon costs or there is no cost to base the rest if the prices on."

"But real world capitalist economies have many prices – and in many cases a majority of prices – that are set by price administration."

Of course businesses intend to sell their goods at above their production cost so they can make a profit. This doesn't refute what Mises says. The business is still going to match the supply of the good to the demand of the good.

If I produce a good for $1000, obviously I'll only keep producing and selling it for over $1000. If I price it at $1100, there will then be n people demanding it. I don't want to under-produce nor over-produce the good, so I'll produce n units of it - I'll equate supply and demand.

Mises wasn't implying that supply and demand are always set first, and then prices are set. He merely states that they are related, and that supply will tend to equate to demand. Look at some of the quotes you've highlighted, for example:

"The characteristic feature of the market price is that it equalizes supply and demand"

or:

"Competitive prices are the outcome of a complete adjustment of the sellers to the demand of the consumers".

Businesses setting administered prices only tell us that they are looking to make a profit, and won't want to sell goods if they are not profitable. But what determines the size of that profit? Supply and demand, as Mises said. The administered prices they initially give their products are just estimates. The prices can, and most likely will, still fluctuate based on consumer demand. If the business can get away with charging a higher price, for example, then they will. You're treating administered prices as if they are fixed, and whatever price is set initially will stay there. They aren't. They will ultimately be set, again, based on consumer demand and supply.

You still don't understand what I'm saying. Mises was explaining the relation of price to supply and demand in the long run, in the ERE. You're talking about the initial price given to a good.

"The mark-up prices are precisely ones that generally do not fluctuate based on consumer demand"

Firstly, thanks for acknowledging that they can fluctuate. They very fact that it's possible for them to fluctuate means that other forces, namely supply and demand, influence them. Secondly, mark-up prices do change more often than you imply. Thirdly, nothing in your response refutes what Mises said. No where does he deny that businesses give initial prices to goods. You have to give an initial price to a good. Retailers don't sell their new products without a price.

In addition, the administered price itself is influenced by demand and supply. The only reason the goods are produced in the first place, and given the administered price, is because they are expected to be in sufficient demand at that profitable price.

(1) "Mises was explaining the relation of price to supply and demand in the long run, in the ERE."

No, he isn't. I have read the passage several times and there is no mention of the ERE.

(2) You're the one ignorant here. Nobody is saying -- or ever said -- that mark-up price never change.

However, the changes tend to be due to changes in total average unit costs or adjustments to profit mark-up.

Just because there are responsive to supply in that sense and minimally responsive to demand, it does not follow that Mises's price theory is vindicated.

(3) "In addition, the administered price itself is influenced by demand and supply. The only reason the goods are produced in the first place, and given the administered price, is because they are expected to be in sufficient demand at that profitable price."

You are forced to reduce Mises's price theory to a highly weak form quite different from its original meaning.

(3) No where does he deny that businesses give initial prices to goods.

And nobody said that he denies that "businesses give initial prices to goods". You're inventing straw man arguments.

You're trying to say that, because prices are always above their corresponding production costs, the prices must be determined by the production costs. Correlation does not equal causation. The reason prices are above their production costs, as I've said, is because they intend to make a profit - plain and simple.

Think about this way: Do consumers care at all about how much a good cost to produce? No. They're willing to pay a certain amount, and that's it. Prices are only influenced by demand, and businesses will work to match the supply to the demand.

it does not follow that Mises's price theory is vindicated.

I don't know what else to say, except: Yes, it does. Prices are always influenced by supply and demand.

You are forced to reduce Mises's price theory to a highly weak form quite different from its original meaning.

(1) "You're trying to say that, because prices are always above their corresponding production costs, the prices must be determined by the production costs. Correlation does not equal causation"

We know they are determined by production costs because that is business people say in survey and after survey:

“For several years a group of economists in Oxford have been studying problems connected with the trade cycle. Among the methods adopted is that of discussion with business men, a number of whom have been kind enough to submit to questioning on their procedure in various circumstances: and among other matters in the questionnaire were inquiries about the policy adopted in fixing the prices and the output of products.” (Hall and Hitch 1939: 12).

An overwhelming majority of the entrepreneurs thought that a price based on full average cost (including a conventional allowance for profit) was the ‘right’ price, the one which ‘ought’ to be charged. In some cases this meant computing the full cost of a ‘given’ commodity, and charging a price equal to cost."

Again I suppose your attempts are commendable for the sake of sheer effort, but at this point I'm convinced you simply cannot grasp the function individual psychic valuations play in all exchange. Obviously you deny praxeology as such. Perhaps you should engage a different author instead of Mises. He clearly uses language you're either struggling to follow or you simply cannot grasp the implied portions. Rothbard covers much of this in a drier, more easy to understand manner.

At this point I would suggest you stop trying to disprove Austrian price theory, and start asking why they've always got a response, and why that response is so typically that your empirical examples still fit the theory. I'm suggesting you should try harder to understand the theory before you try to dismantle it. Clearly we see something you don't.

"I'm convinced you simply cannot grasp the function individual psychic valuations play in all exchange."

If this is supposed to mean that all people subjectively value the goods they buy (true), and one person would need to value the good they buy more highly than the money/other good they exchange for it (also true), I understand these concepts perfectly well.

Referring to those concepts is a feeble red herring that refutes nothing I have said above

The internet filled with loud mouth know nothing vulgar Austrian twits who do not even understand their own Austrian theory.

So you admit that consumers have to value the product higher than the money at any given price to make an exchange. And on the other end of the deal, that producers must also value the money more than the product? If both these are true, then regardless of how they calculate and set their prices I.e. formulas, cost calculations, arbitrary whims... They still won't set prices below where they value the goods. The rest of the theory flows logically from there. Do you view the world like numbers reeling in The Matrix? Get real man. You're not wrong about how some manufacturers set prices, you're wrong about how you interpret the theory. Stop reading Mises. Try some other authors.